Time for Your Annual Checkup
By AICC Staff
November 22, 2019
This is the time of year when most of you are pondering your future and looking at your budget for the new year. You are thinking about updating your estimating system and contemplating plant upgrades, new equipment, improved personnel, new software, upgraded systems, and infrastructure improvement. You need it all, don’t you? And if you had unlimited capital reserves, you might try to do it all. But first, it’s time to get out the blood pressure cuffs, the EKG, the proctoscope, and all the other nasty and invasive devices, because Dr. Klingher (honorary doctor of converting finance) recommends you take your annual financial physical.
First, we need to prepare by gathering some information and adjusting your financial statements. Generally accepted accounting principles in the United States force you to record your assets at historical cost and make you clutter up your balance sheet with intangible assets and deferred charges that have no real tangible value. In addition, rent expense is shown on a straight-line basis, so there may be an asset or liability on the balance sheet created from this calculation. Starting in 2020, this is going to get a lot worse, since the Financial Accounting Standards Board (FASB) is going to require all of you to show all of your leases that are greater than one year in duration as a capitalized asset and a hypothetical liability if you want to say that you are in compliance with generally accepted accounting principles. So, in preparation for your company’s annual physical, do the following:
- Calculate your fair market value tangible net worth by taking total equity and subtracting out all of the intangible assets (including the straight-line rent calculation), any deferred taxes, or other deferred charges.
- Adjust this tangible net worth to fair market value by subtracting out the depreciated value of all of your fixed assets and adding back a conservative fair market value.
- Gather the following information as of the date of your most recent financial statements (presumably the nine months that ended Sept. 30)—MSF produced, MSF shipped, total direct labor hours, total major machine hours (setup and run), depreciation and amortization expense, and an estimate of personal expenses, excessive salaries, and other family “perks” that the business is paying for.
The following are Dr. Klingher’s prescribed tests to evaluate the relative health of your business:
- Leverage ratio – Compare your total liabilities to your adjusted fair market value equity. This is your debt-to-tangible-equity ratio, which shows how much leverage you are employing in your operation. A ratio of 1:1 is conservative, and a ratio of higher than 3:1 indicates high leverage. The higher this ratio is, the greater the chance that your business may fail. Bankers look at this ratio religiously, and so should you.
- Cash-flow coverage – Take net income plus depreciation plus interest expense, and compare this to the current portion of your long-term debt. This is your cash-flow coverage ratio. If it’s less than 1:1, you are in danger of running out of money, because you are not generating enough money to pay off your bank debt. This is another one that all bankers look at.
- Current ratio and your quick ratio – The current ratio is total current assets divided by total current liabilities. A strong company will have a current ratio of 1.5:1 or better. If this number is less than 1:1, you are in danger of insolvency. The quick ratio is generally cash plus cash equivalents plus accounts receivable divided by total current liabilities. If this number is 1:1 or better, you have excellent liquidity, and if it is less than 0.75:1, then you may be having paying your bills. Many people feel that since inventory turns very quickly for converters, that inventory should be added to the numerator. However, many of you carry a lot of finished goods inventory that is not covered by contracts, so for most of you, I would exclude it.
- Return on equity – Take your net income plus the estimated amount of family perks, and divide it by the tangible equity calculated above. This is your return on equity. Shareholders must decide whether employing their capital in a risky investment like a small closely held company is smarter than employing it in other investment vehicles. You can probably get a fairly risk-free pretax return investing in publicly available investment vehicles of 3.5%, so one might argue that if you are getting less than two times that (7%), you might be better off selling the asset and investing in fairly risk-free investments.
- Return on sales – Take your
net income plus the estimated amount of family perks, and divide by sales. The best independent converters are showing close to 15%, just to give you a sense of what is possible. How do you compare to the best?
- EBITDA (earnings before interest, taxes, depreciation, and amortization) as a percentage of sales – Add EBITDA plus family perks, and divide by sales. There are companies exceeding 20% in this category.
- Plant labor productivity – Divide SF produced (SF shipped if you are a sheet plant and don’t have the produced figure) by direct labor hours for each month of the year and the prior year. This one is hard to benchmark from company to company, because it is a function of the setup and run speeds of your equipment and your mix of sales. Obviously, the plants with more up-to-date equipment that have longer runs and fewer multimachine operations will have a higher productivity number. If this statistic is improving and the trend line is pointed up, you are moving in the right direction. If it is moving down, you need to take action.
- Material margin (or contribution) dollars per major machine hour – Sales less all materials (or all variable costs) divided by the number of major machine hours for the period. Since machine hours are generally your most finite resource, how much margin you generate per machine hour is extremely important. If you have five major machines running one shift, and your average margin per hour is $250 and your uptime percentage is 75%, then on average, each machine is generating $375,000 of margin. It is doubtful that you could run a company and pay for the equipment at this level. Ultimately, you need to break this down as best you can by machine as at least a sanity check for how you are pricing your business. More mechanized plants with newer equipment will have a much higher number than plants with older equipment. This is another figure that you need to benchmark against yourself to see whether it is improving or not. Remember, understanding what a machine hour is worth is more important than what you perceive its fully loaded cost is.
- Fixed costs per shipping day –
Add all of your cost buckets (factory overhead, selling, general and administrative, and any other cost that is below the contribution line in your business), and divide by the number of shipping days. This gives you the amount of fixed costs that you need to cover with margin dollars on a daily, weekly, or monthly basis. You can calculate a minimum hourly charge by dividing the total fixed charges by the number of machine hours.
If you are sure that you aren’t employing too much leverage, have good liquidity and cash flow, are making reasonable returns on assets and equity, are getting good productivity from your employees, and are pricing business at levels that yield a good hourly rate at the machines, then you are cleared to invest heavily. If not, you need to be more cautious in your capital spending and focus on the areas that will yield the most improvement.
Mitch Klingher is a partner at Klingher Nadler LLP. He can be reached at 201-731-3025 or firstname.lastname@example.org.